Human nature is like water, it constantly looks for the path of least resistance.
So when it comes to looking for meaning within infinitely complex systems, say the global economy or stock market, we all tend to rely on metrics and measures that have worked well in the past.
“The four most dangerous words in investing are ‘this time it’s different’" Sir John Templeton
“This time it’s different”. Usually said sarcastically by a senior Investment Manager to make a junior feel small. Inference - “what could you possibly know, you haven’t been in this game anywhere near long enough”.
But here’s the trouble. Sometimes it is different. And if you are lazily reliant on old mental models and measures, you can get your posterior handed to you by a market that couldn’t care less what age you are.
Some examples.
Robert Shiller’s Cyclically Adjusted Price to Earnings (CAPE) model sounds complicated but it is a fairly commonly referred to method of valuing stocks. And it has traditionally provided a good indicator as to whether stocks are over or under valued.
But since 2010 Shiller’s CAPE ratio for the S&P 500 (the US stock market) has been above 20 (historically a level indicating significant over-valuation).
And during that time, the S&P has done this.
Source: FE Analytics. Returns shown in GBP terms.
If you had sold out of the S&P based on this (eminently sensible) model in 2010, you would have missed out on one of the best periods of return for the US market ever.
Here’s another example. In 1986 an economist by the name of Cam Harvey showed that a “yield curve inversion” had been a perfect predictor of recessions in the US since the 60’s.
And since his original paper in 1986, Mr Harvey’s signal continued to have a perfect track record of predicting recessions within eighteen months of the date of inversion.
That is, until 2022 when the yield curve steeply inverted. Since then, not only has the US avoided a recession, but it’s economy seems to be in pretty rude health.
Source: US Bureau of Economic Analysis, via St Louis Fed. The chart shows Gross Domestic Product, the measure most widely used to define economic growth.
Of course we should pay attention to history when we construct an investment strategy. It would be pretty silly to follow an approach which has never worked before. My own investment philosophy is based on the foundation of market history.
But we mustn’t get complacent. Sometimes strange things happen and we need to beware of false signals.
Experience offers it’s own trap - “I’ve seen this movie before”. Maybe you have, maybe you haven’t. Maybe there’s a big twist.
As time marches on and we all get more years of experience under our belt, I don’t think that it is controversial to observe that most of us naturally become more risk averse. As net worth rises, we all have more to lose – every time the market falls the hit in terms of pounds, shillings and pence is bigger.
Only a robot would be the same person they were when they were twenty, but there is the danger that risk aversion gives way to paranoia.
We know that human beings tend to attribute higher probability to memorable events, and that traumatic events are naturally more memorable to us. There is a real chance therefore that we can erroneously assume that the low probability traumatic events that define our lives (say, for example, a pandemic) are excessively likely to occur again.
To the hammer, everything looks like a nail. And if we end up constantly looking for signs of disaster everywhere, we might just forget to make a few quid.
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